AA Seminar 08 Presentation-PS 6 Handouts

• Conversion to IFRS: Jan 1, 2011• Insurance contracts: IFRS 4; keep current basis of accounting until Phase II effective 2012 or 2013 • Investment contracts: IAS 39 Financial Instrumen

of Actuaries

L’Institut canadien des

actuaires

• Conversion to IFRS: Jan 1, 2011

• Insurance contracts: IFRS 4; keep current basis

of accounting until Phase II (effective 2012 or 2013)

• Investment contracts: IAS 39 Financial Instruments

• Service contracts: IAS 18 Revenue (similar to CGAAP)

 Most significant impact:

Investment contracts, and potentially Embedded Derivatives

Insurance and Investment Contracts: Actuarial Liabilities

Investment Contracts: IAS 39

Phase I January 1, 2011:

Phase II January

1, 2012, (or later):

Insurance Contracts:

new IFRS standards

Current CGAAP:

Embedded Derivatives : IAS 39 Fair Value option

• IFRS definition of Insurance Contract:

significant insurance risk from another party (the

policyholder) by agreeing to compensate the policyholder if a specified uncertain future event (the insured event) adversely affects the policyholder.’

• Three key criteria:

1) Insured event must adversely affect policyholder2) Insured benefits must be significant

3) Insurance risk must be non-financial: mortality, longevity, morbidity, P&C risks

8 Contract classification (cont’d)

• Significance of insurance risk:

Insurance risk is significant if, and only if, an insured event could cause an insurer to pay significant additional benefits in any scenario, excluding scenarios that lack commercial substance

• Probability of insured event is not considered when assessing significance of risk

• Company determines what it considers as being significant: 5%-10% additional benefits?

• Risks that are created by the contract (lapse, expense) do not constitute Insurance Risk (i.e risk must be pre-existing)

Does the insured event adversely affect the insured?

No The contract is not an insurance contract; consider Investment or Service contract Yes

Identify scenario A, in which insured event

occurs: Example: Death of Policyholder

before end of insurance coverage period

Insured event: Example: Death of policyholder

Determine the benefit payable by the insurer under

Scenario A: Example: Face Amount of $100,000

Identify scenario B, in which insured event does not

occur: Example: Survival of policyholder to the

end of the coverage period

Determine the benefit available to policyholder

under Scenario B: Example: Surrender Value

The contract is an insurance contract:

IFRS 4 applies.

The contract is not an insurance contract; consider Investment

or Service contract

Decision tree (cont’d)

• Once Insurance, always Insurance

• Assessment is made at contract inception

• Contract is assessed as a whole: If significant

insurance risk is present in the contract, then the whole contract is classified as Insurance.

 Then, determine if contract contains:

• Embedded derivative (separate fair value measurement under IAS 39)

• Deposit component (option to unbundle)

• Discretionary participation feature

• Can assess at segment level for blocks that have

“relatively homogeneous risk profiles”

• Lapse/expense risks do not constitute insurance risk

to the direct insurer, but do constitute insurance risk

to reinsurer assuming the risk

 Lapse/expense risk is “pre-existing” to the reinsurance arrangement, and would adversely affect the direct

writer

• Legal entity versus consolidated:

 Situations may exist for related-party reinsurance arrangements, where a contract will be classified differently at legal entity level versus consolidated

Other considerations (cont’d)

 Endowment products / Pure endowments

 Critical Illness/Health/Disability contracts

 Long Term Care

 Group Life and Health insurance (excluding ASO contracts)

 Reinsurance treaties with “significant” risk transfer

 Payout immediate/deferred annuities (life contingent)

 Term certain contingent annuities

 Fixed accummulation annuities which do not contain guaranteed annuitization rates

 Seg funds with no guaranteed minimum returns

 Group contracts with strong “hold harmless”

provisions (terminal/deficit accounting)

 Mutual funds / banking products

• IAS 39 applies:

 Potential asset segmentation issues if commingled with assets backing Insurance segments

 Financial Reinsurance with very limited risk transfers

 Potentially: mutual funds where company acts as

“conduit” / does not have ability to choose/replace investment managers

• Widely expected that IFRS treatment will be similar to existing CGAAP

• DAC implications for service components embedded in investment contracts

ED is:

 not itself considered insurance, and

 not closely related to the host insurance or investment contract

• EDs within Investment contracts do not need to be separately fair valued if the whole contract is measured at fair value

• IAS 39.9: “A derivative is a financial instrument with all three of the following characteristics:

– its value changes in response to the change in a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of prices or rates, credit rating or credit index, or other variable, provided that the variable is not specific to a party to the contract (sometimes called the

“underlying”);

– it requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts; and

– it is settled at a future date.”

• An embedded derivative is defined in IAS 39.10 as follows:

– is a part of a combined (hybrid) contract, which also contains non-derivative components

– combined contract includes an identifiable condition to modify the cash flows otherwise payable; and

– modification of cash flows is in response to a market factor or non-financial variable that is not specific to a party to the contract

• ED that is itself Insurance:

– If cashflows affected by the ED are only paid on a insured/contingent event, then ED itself meets the definition of an insurance contract;

 IFRS 4 applies; exempt from separate Fair Value measurement

• Examples:

– Seg fund GMDB, GMIB, “for-life” GMWB

– CPI-indexing feature in disability contracts

• Definition of “closely related”:

– An ED is “closely related” to its host contract

if the risks inherent in the ED and the host contract are “similar”

– An ED is considered closely related if ED and host contract are so inter-dependent that the

ED cannot be measured without considering the host contract

• Examples “closely related” EDs:

 Unit-linked deposit components (where policyholder AV is expressed in terms of units of underlying fund) are explicitly listed in IFRS literature as being “closely related”

paragraphs AG30 and AG33

• Other Embedded Derivatives at risk of requiring separate fair value

measurement:

 Ceded / assumed GMIB: depending on specifics

of the contract, and whether actual reinsurance recoveries can be viewed as being “payable on

• For non-exempt EDs:

– ED is separately measured at Fair Value under IAS 39 – similar to US GAAP FAS 133; change in value of ED flows through earnings each quarter

– Host contract is measured under IFRS 4 (Insurance), IAS

• Fair value option:

– Similar to USGAAP fair value;

– Maximum use of market inputs, margin for bearing risk, risk free rate + adjustment for own credit and liquidity

• DAC implications:

– No such concept under IAS 39

– If service component embedded in contract, can capitalize certain transaction costs only, provided they are “direct and incremental” to contract

issuance

– Different rules will likely result in difference in what can be capitalized, and opening retained

 Broad definition of “insurance”

 Unlikely to have material amounts of Investment Contracts;

• For Investment contracts: need to understand implications of IAS 39;

 potential asset segmentation issues